Chapter 10 homework

1. Chapter 10 homework • Number 4: Kyoko Yamashita • Number 7: Harry Keyser • Number 11: Audrey Stawecki • Number 12: Scott Anderson • Number 18: Michael Schwager • Alternate: Trevor Thomas

2. Chapter 11 From Short-Run to Long-Run Equilibrium: The Model in Action

3. Curing an Underperforming or Overheating Economy • We can use the long-run model to explain how the macroeconomy self-adjusts to two major problems: • An underperforming economy (recessionary gap) • An overheating economy (inflationary gap) • Hint: it is all about SRAS…

4. The Underperforming Economy and Recessionary Gaps • Symptoms of an underperforming economy: • High equilibrium price level • Real GDP is below the full employment level. • Recessionary Gap • Unemployment is above the full employment level.

5. Figure 11.4(a)The Underperforming Economy: Identification and Elimination of the Recessionary Gap

6. Curing the Underperforming Economy • Excess unemployment puts downward pressure on the nominal wage rate. • Decreases costs of production. • Falling costs increase the profit potential • Producers respond by increasing output. • The short-run aggregate supply curve shifts to the right.

7. Figure 11.4(b)The Underperforming Economy: Identification and Elimination of the Recessionary Gap

8. Curing the Underperforming Economy • What does the adjustment process do? • increases real GDP, reduces the actual unemployment rate, and causes the price level to fall. • Gets us back to LR equilibrium

9. The Overheating Economy and Inflationary Gaps • Symptoms of an overheating economy: • Increasing incomes put upward pressure on the price level. • Real GDP is above the full employment level. • Inflationary Gap • Unemployment is below the full employment level.

10. Figure 11.5(a)The Overheating Economy: Identification and Elimination of the Inflationary Gap

11. Curing the Overheating Economy • An overheating economy will put upward pressure on nominal wages and resource prices. • Increase firm’s costs of production. • Higher costs reduce profits, causing firms to reduce output. • The short-run aggregate supply curve shifts to the left.

12. Figure 11.5(b)The Overheating Economy: Identification and Elimination of the Inflationary Gap

13. Curing the Overheating Economy • What does the adjustment process do? • reduces real GDP, increases unemployment and causes the price level to rise. • Gets us back to LR equilibrium

14. Can we do it? (number 15) • In each case, identify which type of gap is being described: • The full employment unemployment rate is greater than the actual unemployment rate • Full employment real GDP is greater than actual real GDP • The major economic problem is unemployment • When this gap is removed in the long run, the price level rises and real GDP falls

15. Real-World Difficulties of the Long-Run Model • Determining the length of the long-run period: • Production decisions by firms are not made immediately. • Firms and workers may initially overestimate or underestimate the necessary adjustments.

16. Real-World Difficulties of the Long-Run Model (cont’d) • Estimating the full employment level of output: • The full employment level of output can be a moving target over time, increasing or decreasing with changes in resources and technology. • Different perceptions of full employment will lead to different predictions about the behavior of the economy. • Does it seem that our government sits back and lets things happen?

17. Figure 11.6 Conflicting Estimates of Full Employment Real GDP

18. Chapter 11 Homework • Number 1, 4, 8, and 14

19. Chapter 12 The Role of Aggregate Demand in the Short Run

20. Emergence of the Keynesian Short-Run Model • Classical economists thought that an economy will self-adjust to any problems. • Economy will always be at or near full employment. • Called the Long Run Economic Model • The Great Depression set the stage for a new short-run economic model.

21. The Great Depression’s Challenge to the Long-Run Model • Most severe economic trauma in U.S. history. • From 1929 to 1933, the unemployment rate increased from about 3% to almost 25%. • By 1933, real GDP had fallen by almost 27%. • Marriage and birth rates fell. • Participation in radical political movements increased. • Fear was fostered by not knowing what was happening or how to fix it.

22. The Great Depression’s Challenge to the Long-Run Model (cont’d) • Following the long-run economic model, the belief was that the economy would eventually cure itself. • However, during the1930s it didn’t seem to be working • The nation’s short-run suffering required immediate action.

23. The Keynesian Short-Run Model Emerges • John Maynard Keynes was a professor of economics at Cambridge University in England.

24. The Keynesian Short-Run Model Emerges (cont’d) • Keynes’ book, The General Theory of Employment, Interest and Money, was published in 1936. • Arguably the most important economics book of the 20th century • It challenged the accepted long-run macroeconomic model.

25. The Keynesian Challenge to the Long-Run Model • The Keynesian model is a short-run model of the behavior of the macroeconomy that: • Emphasizes the role of aggregate demand and government action in the macroeconomy • Questions the validity of the long-run model as an effective guide for macroeconomic policy

26. The Keynesian Challenge to the Long-Run Model (cont’d) • Compared to the Classical long-run model, the Keynesian model: • Is concerned with the short run • “In the long run, we’re all dead.” • Focuses on aggregate demand • Can be shaped by policy • Suggests that the economy could remain below full employment for prolonged periods • Because markets don’t adjust quickly • Promotes government stabilization policy

27. The Keynesian Model and Economic Policy • In 1933, President Roosevelt proposed—and Congress passed—a wide variety of economic legislation designed to stabilize the economy and put people back to work. • Roosevelt was unwilling for the economy to “fix itself”.

28. Characteristics of the Short-Run Model • Major belief is that full employment is the exception rather than the rule. • Advocates an aggressive approach to economic policy that attacks and cures short-run problems quickly and effectively.

29. Characteristics of the Short-Run Model (cont’d) • Three pillars of the model • Each is a contradiction of a characteristic of the long-run model. • Challenges: • Say’s Law • The loanable funds market • Flexible prices and wages

30. Challenge to Say’s Law • Say’s Law = “supply creates its own demand.” • Keynes taught that demand creates its own supply. • Aggregate demand motivates firms • Produce a good only if there is a demand for it. • If something is wrong with the economy, it’s due to a problem with aggregate demand.

31. Challenge to the Loanable Funds Market • Long-run model interest rate adjusted so that the quantity supplied of funds equals the quantity demanded of funds. • Saving was channeled into investment spending. • Short-run model no mechanism converts saving to investment spending. • Factors other than the interest rate can also influence saving and investment: • Disposable income has a major impact on saving. • Expected return on investment affects the decision to invest.

32. Challenge to Price and Wage Flexibility • Long-run model  freely adjusting prices and wages. • Based on an economy comprised of small, competitive firms, workers negotiating their own wages, and minimal government. • Short-run model  prices and wages are “sticky downward.” • Based on an economy characterized by: • Large firms with some control over the prices they charge • Workers represented by strong unions with the power to negotiate wages and other benefits

33. Price Inflexibility • Long-run model  AD decline leads to lower prices as the short-run aggregate supply curve shifts to the right. • Firms are not required to reduce output or employment. • Short-run model little pressure for firms to cut prices. • AD declines  firms cut output and employment. • Unless and until prices adjust, the economy will remain below full employment.

34. Wage Inflexibility • long-run model  decline AD workers accept lower nominal wages to keep their jobs. • short-run model  workers resist accepting lower wages. • Wage stickiness doesn’t allow the economy to self-adjust to a decline in aggregate demand. • Employers will ultimately have to lay off some workers.

35. The Importance of Aggregate Demand in the Short Run • The long-run model  aggregate supply runs the economy and cures for any economic problems. • Keynesian short-run model  aggregate demand causes and cures economic problems.

36. Figure 12.1(a) Impact of Changing Aggregate Demand on Short-Run Equilibrium

37. Figure 12.1(b) Impact of Changing Aggregate Demand on Short-Run Equilibrium

38. Changes in Aggregate Demand • Changes in aggregate demand can result from • Consumption • Investment • Government Spending • Net Exports • C+I+G+(X-M)

39. The Role of Consumption • Consumption • Is the largest component of aggregate demand in the United States • Represents about 70% of total GDP • Is very stable and difficult to change

40. The Role of Consumption • Factors that can affect consumption: • Household wealth and debt • Consumers’ optimism or pessimism about the future • The level of real interest rates • The overall price level • Households current stock of durable goods

41. Consumption and Income • Most important determinant is disposable income. • Income that remains after all taxes are paid • As disposable income increases, households generally spend more dollars. • But…they spend a smaller percentage of each additional dollar of disposable income.

42. Consumption and Income (cont’d) • The marginal propensity to consume (MPC) is the fraction of additional income that is spent on consumption: • Example: Suppose a family receives a $600 tax cut, of which it spends $400 on consumption goods. • The MPC is then $400/$600 = .67

43. Consumption and Income (cont’d) • The marginal propensity to save (MPS) is the fraction of additional income that is saved: • Example: Suppose a family receives a $600 tax cut, of which it saves $200. • The MPS is then $200/$600 = .33

44. Consumption and Income (cont’d) • The value of the MPC plus the value of the MPS must equal 100% • Disposable income can only be consumed or saved.

45. Can we do it? (number 4) • Based on the following information calculate the MPC • What is the MPS for this sample household? • If the income increases to $12,900 and the MPC remains the same what will be the amount of consumption at the new level of income?

46. Answer anyone?? • The MPC and MPS for this household are:

47. The Role of Investment • Unlike consumption, investment can and does easily change. • Depends on: • Business expectations about economic performance • Interest rates • Tax policies

48. The Role of Investment • Can be easily but not reliably changed. • Not a good candidate for policy makers who want to change aggregate demand.

49. The Role of Net Exports • The amount of net exports is determined by: • The value of the dollar • If the dollar appreciates, U.S. imports would increase and U.S. exports would decrease. • But value is determined in a huge market, policy makers can’t do much to affect its value. • The economic health of other nations • Cannot be influenced by U.S. policy makers

50. The Role of Government • So…it is hard to use consumption, investment or net exports to alter aggregate demand. • So…Keynes concluded that it was up to the government to use its own spending and taxes to change aggregate demand. • The government could: • Be the spender of last resort, or • Cut taxes to encourage consumption.